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Center for the Study of Economic Liberty
at Arizona State University
Policy Report
No. 2015-01
May 12, 2015
PATHS TO REFORM
A Policy Roadmap to Elimination of the Arizona Income Tax
BY STEPHEN SLIVINSKI
Senior Research Fellow, Center for the Study of Economic Liberty at Arizona State University
EXECUTIVE SUMMARY
RESTRUCTURING THE STATE’S REVENUE SYSTEM to rely more on consumption
taxes (i.e., the transaction privilege tax, commonly known as the “sales tax”) and eliminating
the personal income tax can be beneficial from both an economic perspective and a public
policy perspective. In the following study, I explain how the reform can be accomplished
while still maintaining budget balance over six to eight years.
The case for consumption taxes rests on the fact that, in comparison to income taxes,
consumption taxes are less harmful to investment and job-creation. That’s largely because
consumption taxes are “neutral” with respect to investment decisions over time and between
industries. They also tend to be more stable as a revenue source over time, and further reliance on them could reduce the volatility of state general fund revenue.
The policy case for reforming the tax system in Arizona recognizes that our state is
competing for capital and workers. Low tax burdens will not be enough. We must be more
competitive, particularly with states that have no income tax and with states that are taking
greater strides than Arizona at reforming their tax codes.
Over the past few years, lawmakers have helped to stay Arizona competitive by lowering
corporate taxes and commercial property taxes. However, state policymakers have done little
Published by the Center for the Study of Economic Liberty at Arizona State University
Tempe, Arizona 85287 | (480) 965-1131 | economiclibertyasu.com
Center for the Study of Economic Liberty | Policy Report
over the past decade to reform personal income taxes
jeopardize our relatively good standing in terms of over-
or review the revenue system as a whole and determine
all state tax burden.
whether it’s one that works best for the Arizona econo-
Other options for revenue neutrality exist, such as
my. This is particularly important with regard to the per-
increasing user fees associated with automobile registra-
sonal income tax because it is, in ways that many do not
tion or capping the homeowner property-tax rebate. Yet
notice, a business tax too: “pass-through entities” like S-
another option would be to avoid being too doctrinaire
corps, LLCs, sole proprietorships, and joint partnerships
about revenue neutrality on the tax collections side and
pay their business taxes through the personal income tax
instead make room in the budget through spending
code. Since these types of businesses account for over 97
reforms to allow a commitment to an ultimate goal of
percent of all employers in the state, ignoring the impor-
phasing out the income tax as quickly as possible. The
tance of income tax reform more broadly leaves behind
best option would be to make reforms to spending pro-
the single-largest share of business types.
grams that would reduce state spending obligations and
There are at least five main policy paths available
to state policymakers pursuing tax reform. This study
outlines each of these options for the purposes of serving
as a “tool kit” for policymakers. Each scenario assumes
a critical factor: spending discipline in the state general
fund budget, which should be an important factor in any
long-term plan for tax reform. Tax reform can also be
envisioned within the context of revenue growth of the
type exhibited over the past 15 years and that economists
suspect will continue in the near future.
use the savings to “buy down” the income tax rate. An
example of that would be reforming the urban revenue
sharing program that is anchored to the current personal
income tax.
Arizona policymakers have a unique opportunity to
consider such important reforms now that state government has reached a semblance of structural budget balance for the first time in years and the state prepares to
face a new era of economic growth. This study can serve
as a roadmap for such a policy discussion.
If policy makers desire revenue neutrality, tax reform
can point the way toward more reliance on the sales tax
by expanding the sales tax base to some services that are
not currently included as a means to “buy-down” the
INTRODUCTION
Governor Doug Ducey has promised a goal of giving people tax relief each year he is in office. He also has
stated that he believes that the state is due for tax reform
There are at least five main
policy paths available to state
policymakers pursuing tax
reform. This study outlines each.
and that phasing out the personal income tax should be
put on the table as a realistic reform option.1 In addition,
a joint legislative task force in 2013 also considered some
of the technical aspects of income tax reform, indicating
a receptiveness among the leadership and members of the
legislature to consider big-picture reforms to the state’s
income tax rate to zero over time. This is a reform that
can be made in a way that shields the poor and also di-
tax system.2
As we’ll see, a substantial amount of peer-reviewed
minishes the distortions in the economy while stabilizing
literature in tax policy analysis suggests that elimination
the revenue stream. Yet it should only be considered as
of the state income tax would greatly benefit any state
a means to phase down the income tax. Any action that
that undertakes reforms to do this. This study makes an
increases the tax burden would be counterproductive and
economic and policy case for such a reform and outlines
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a number of different scenarios that could make such a
paper, the income tax can indeed be phased-out over a
tax reform a reality.
six or seven year period if the state experiences average
My goal in this study is to provide other research-
annual revenue growth rates typical of what the state has
ers and policymakers with a realistic picture of different
experienced over the past 15 years. It will require overall
reform options. Each option presents different challenges
spending discipline that holds spending to a strict base-
to lawmakers, but each is also based on an important
starting point in discussing reform: tax reform throughout my discussion doesn’t need to deprive the state
general fund of revenue needed for necessary functions.
“Revenue-neutral” tax reform is possible and can, in fact,
still be beneficial to economic growth. However, defining success as collecting just as much revenue as before
to carry out the same functions of government is not the
only path. Savings from reform to spending programs
could “pay for” tax reform and simultaneously put Arizona state government on even firmer budgetary footing.
Policymakers should be concerned about how the
A substantial amount of peerreviewed literature in tax policy
analysis suggests that elimination
of the state income tax would
greatly benefit any state.
line, but tax reform could also include reform of a number of spending programs (including urban revenue sharing) or an expansion of the state sales tax base to some
services as long as overall tax burdens do not increase.
state tax system extracts revenue. The Arizona tax system
has a number of attributes that distort the state economy
and diminish the ability of the state to attract new in-
A CASE FOR TAX REFORM
The first question that needs to be addressed is why
vestment and drive job creation. Among them is the
Arizona should embark upon such a tax reform. As we
current income tax. Since states are competing with each
shall see throughout this study, there are a number of
other on the dimension of tax policy, and other states
reasons to do so. Primary among the reasons is the reality
have moved toward elimination of income taxes in favor
of economic competition between states, as well as the
of consumption taxes or had the pre-existing advantage
goal of achieving higher economic growth. In addition
of having no income tax, Arizona is losing out in the race
to the economic benefits, tax reform could also make the
to attract investors and jobs.
state’s general fund revenue more stable over time.
Since a fundamental reform of the state’s tax system
Across the states, much of the debate over tax reform
to reduce or eliminate the state income tax is a goal of
is over tax burdens – how much taxpayers pay to the gov-
the new governor, an examination of the various reform
ernment in per capita terms each year. This is certainly
options is a worthwhile exercise to understand how we
an important concern as high tax burdens can inhibit
get from “here” to “there” and also to help stakeholders
economic growth.3 However, in the case of Arizona, the
anticipate the possible consequences of reform.
concern about overall tax burdens as a reason for tax re-
The paper concludes with a list of possible reform
form may not be as worrisome when compared to how
options that would eliminate the personal income tax in
other states fare. In terms of total per capita state and
Arizona. The most realistic ones are those that phase out
local tax burden, Arizona ranks 16th lowest in the nation.
the income tax over time starting in fiscal year 2017 (the
That’s the exact opposite of where the state was in 1990,
general budget for which will be considered in the 2016
when it had the 16th highest state and local per capita tax
legislative session). Based on the analysis outlined in this
burden in the nation.4
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Arizona’s tax cuts in the 1990s lowered the income
aren’t just a function of how policymakers carve out
tax burden. In 1995, Governor Fife Symington signed
special exemptions and credits for particular industries or
into law a substantial reduction of income tax rates,
categories of activities, although those are clearly distor-
which brought the top rate from 7% to 5.6%. This tax
tionary. Even an income tax free of politically motivated
cut alone was enough to bring Arizona to the national
loopholes is non-neutral with respect to investment deci-
average in terms of tax burdens after a number of prior
sions over time. A truly neutral tax system should treat
years far above the national average. Later, Governor Ja-
savings and consumption evenhandedly. In other words,
net Napolitano (in 2006) signed into law further reduc-
it would have a neutral impact on a person’s decision to
tions to the income tax rates that eventually cut the top
save or consume an additional dollar.
rate to its current level of 4.54%.
5
Since 2006, the focus in Arizona has strayed away
This is far from an idle or merely academic concern.
The microeconomic decisions made by every individual
from reform of the income tax; instead, greater attention
add up in the aggregate to large macroeconomic pat-
has been paid to creating new tax credits to encourage
terns. Nor are these decisions made in a vacuum. They
specific types of behavior in order to receive a tax cut.
are made contingent on assumptions and expectations
While Arizona lawmakers have been busy pondering tax
about the future and a knowledge of alternative uses of
credits, states like North Carolina and Oklahoma have
their money. If a tax system penalizes saving and invest-
pursued income tax reforms, catapulting them ahead of
ing, there will be less of that activity – and, with it, fewer
Arizona in terms of potential economic competitiveness.
business starts, lower productivity, and lower job growth.
This acknowledgment of past good tax policy decisions should not be read to suggest that Arizona policymakers can’t or shouldn’t continue to find savings in
the state government budget and pass the savings on to
taxpayers in the form of lower taxes. Lowering the cost of
government could indeed translate to lower tax burdens
for Arizona residents and businesses and that could generate some additional economic growth at the margin.
Tax reform that does not break the budget, however,
can still create important economic growth potential
through important changes to how we tax economic activity in Arizona. This type of approach to fundamental
tax reform should be the next frontier. Low taxes are no
longer enough. To chart the right path, policymakers
should understand how the current system distorts business and economic decisions as well as what the current
system does well and poorly.
ELIMINATING THE INCOME TAX CAN REDUCE DISTORTIONS
IN THE ECONOMY
Income taxes, by their nature, create economic distortions. The distortions that come from income taxes
4
An example may be helpful in understanding how
income taxes skew economic decisions. Table 1 depicts
three different scenarios. The first depicts a world in
which there are no taxes. The second scenario depicts a
world with a 30 percent income tax. The third depicts a
world with a 30 percent consumption tax.
Income taxes, by their nature,
create economic distortions.
Assume that in each scenario a worker has just received an extra $2,000 in income. (The person in this
example could just as easily be a businessperson looking to invest in his or her own business by buying new
machinery or expanding a facility.) He has a decision to
make: either spend the money or save the money. In each
scenario, assume the person consumes half and saves
half. Also, assume the rate of return on savings (i.e., the
interest rate) is 10 percent.
In Scenario 1 – the world without taxes – the price
ratio of current consumption to future return on savings
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TABLE 1: How Income Taxes Distort Investment Between Time Periods
Scenario 1
No Taxes
A. Current Pre-tax Earnings
B. Current Tax
C. Current After-tax Consumption
Scenario 2
30% Income Tax
Scenario 3
30% Consumption Tax
Current
Consumption
Current
Saving
Current
Consumption
Current
Saving
Current
Consumption
Current
Saving
$1,000
$1,000
$1,000
$1,000
$1,000
$1,000
$0
$0
$300
$300
$300
$0
$1,000
$0
$700
$0
$700
$0
D. Current After-tax Savings
$0
$1,000
$0
$700
$0
$1,000
E. Future Pre-tax Annual Return
$0
$100
$0
$70
$0
$100
F. Annual Tax on Return
$0
$0
$0
$21
$0
$30
G. Future After-tax Return
$0
$100
$0
$49
$0
$70
$1.00
$0.10
$1.00
$0.07
$1.00
$0.10
Price Ratio: Future After-tax Return
(G) & Current After-tax Consumption
Source: Michael Schuyler, Consumption Taxes: Promises and Problems. Institute for Research on the Economics of Taxation, 1984.
is $1.00 to 10 cents. In other words, the return on every
taxes don’t inhibit the amount of economic activity in an
dollar of foregone present consumption (i.e., savings)
economy. Higher taxes will always translate to having less
will be 10 percent.
money for the private sector to consume or invest. What
In Scenario 2, the worker is taxed on his current in-
the example does indicate, however, is that the decision to
come and also on the income he earns through savings.
do one or the other will be far less influenced by the tax
This is a form of double taxation because the money is
code in a state that relied on taxes based on consumption,
taxed when it is earned as income, and the interest on
not taxation of the mere act of earning income.
the savings (the rate of return) is also taxed because it
In fact, this is just the tip of the iceberg when it
is understood to be income regardless of whether that
comes to biases against productive activity inherent
return on investment will be re-invested somewhere.
in the nature of income taxes. For instance, creating a
Therefore, the price ratio of current consumption to fu-
workable definition of income – whether it should in-
ture return on savings is $1.00 to 7 cents. The tax code
clude interest income or not, for instance – is actually
in this scenario disadvantages saving and investing and
much harder to do than defining consumption. Even
thereby gives a differential preference to consumption.
by this basic analysis, taxing consumption instead of in-
To put it another way, the income tax as constructed
come eliminates the penalty on saving and investing and
here – which mimics the current federal and Arizona
thereby creates a more neutral tax system. In essence, it is
income tax – creates an economic distortion by encour-
the only possible system that is as non-distortionary as a
aging consumption at the expense of saving by reducing
world in which there are no taxes at all.
the rate of return of saving.
In Scenario 3, the price ratio between present and
An economy less distorted by a sub-optimal tax system would be expected to perform better economically
future consumption is identical to that in the no-tax sce-
than others. Indeed, the empirical analysis of the real-
nario. That is because consumption taxes eliminate the
world evidence shows that states with lower taxes, better
double taxation of saving. Thus, the consumption tax
tax structures, or the lack of an income tax in particular
is truly neutral because it does not bias the decision of
do see higher levels of economic growth.6 Perhaps not sur-
a taxpayer to save or consume. This does not mean that
prisingly, people making decisions on where to move also
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favor states with better tax environments probably largely
Corporate income taxes tend to be levied on a spe-
as a result of the healthier economies they find there. Large
cific type of large company (C-corporations), but they
increases in net migration into states with no income taxes
are often mitigated by various credits (which, on average,
have been ongoing for the past couple of decades.
create economic distortions themselves). Yet, lowering
TAX REFORM CAN MAKE THE BUSINESS CLIMATE MORE
FRIENDLY
States are in competition for business investment,
be it homegrown or relocating from other states. If the
tax climate of a state is, on average, hostile to capital
formation or a state maintains a punitive tax burden on
businesses and the investments they make, it will lose
out to other states that offer better tax treatment. There
is substantial evidence that a business tax climate, when
properly measured, has an impact on economic growth.7
In Arizona, the focus of business tax reform has
tended to be on the property tax and the corporate
income tax. There are good reasons to focus on these:
property taxes can, indeed, be a large expense for businesses and can severely handicap a business’s ability
to grow. This is especially true in Arizona, which has
some of the harshest urban property tax burdens in the
country for commercial and industrial property8 There
has been some movement toward remedying this: in
corporate income tax burdens in a general way is important because corporate taxes are a form of “invisible”
taxation that is ultimately passed down to consumers,
shareholders, and workers of the taxed company.10
In the sense that corporate income taxes create adverse economic effects, lowering corporate tax rates is
indeed a way to make a tax system less distortionary. To
that end, Arizona has made some good strides: the state
corporate income tax rate is scheduled to fall from 6.5%
(the rate for 2014) to 4.9% by 2017. In addition, various provisions to carry-forward net operating losses have
been made more generous to make Arizona more comparable to states that already allow such carry-forwards.11
These tax phase-downs must continue.
However, the corporate income tax generates a small
overall share of state revenue – only about 7% in 2014,
for instance. Since it’s such a small part of Arizona’s revenue stream, changing the economic growth trajectory
through innovative corporate tax reform seems unlikely.
2011, the state legislature passed, and Governor Jan
In addition, a tremendous amount of economic activity
States are in competition for
business investment, be it
homegrown or relocating from
other states.
rations are higher-profile businesses that capture media
is generated by small businesses, even though big corpoattention. Small businesses, like S-corporations, LLCs,
and partnerships make up over 97% of all employers in
the state and amount to over 40% of the private workforce.12 Also, many small businesses are entrepreneurs
who are self-employed and don’t have any employees.
Brewer signed, a tax package that will lower the “assess-
But unlike their C-corp counterparts, all of these types
ment ratio” of commercial property – the percentage
of small businesses – called “pass-through” entities be-
of value used to calculate a company’s taxable property
cause, for tax purposes, their profits are passed through
base – from 20% (starting in 2013) to 18% by 2016.
to the shareholders and owners – are taxed as individuals
There were also changes made to allow more generous
through the personal income tax and haven’t had much
depreciation write-offs and raised exemption levels for
relief thanks to the prolonged focus on corporate taxa-
property that is taxed under the business personal prop-
tion. As such, it may be worth thinking of the personal
erty tax.9
income tax as not being merely a tax that individuals
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pay but one that is also paid by the single largest share of
employer-types in the state.
States, however, may not have been automatically following the federal tax code on this matter. Some actively
It’s important, therefore, to consider how invest-
opted to conform their state tax codes with the federal tax
ment is treated by the state income tax within this con-
code on these specific provisions while others opted not
text. A better tax system would be one that introduces
to. Thirty-three states eventually opted to conform to the
the least number of distortions in behavior, and an opti-
federal rules on expensing and bonus depreciation, leaving
mal tax system (as we’ve already seen) would be one that
those that didn’t at a competitive disadvantage. Arizona
has a neutral stance toward investment decisions.
did conform for one year (2013) to the instant expensing
One of the distortions in the current tax system is
provision but when that year was over, Governor Brewer
the treatment of depreciation of assets. When a business
vetoed a bill to make that expensing provision permanent.
owner decides to make a capital investment in his busi-
(As for bonus depreciation, Arizona still only allows 10%
ness – think of a restaurant owner considering whether
of the federal bonus making it one of 28 states not to fully
to expand the kitchen by buying a new oven or a small
conform to those federal rules.)
manufacturer eager to invest in a 3D printer – one of the
questions they have to answer is whether the investment
will yield a return over time. Tax rules usually allow only
a small portion of the initial cost of investment to be deducted in the first year and a declining amount each year
to take into account the decreased value of the machine,
also known as “depreciation.” But this system by its very
nature requires an understatement of the cost of doing
business in the first year and then, when you take into
account even nominal inflation, may mean a business
It may be worth thinking of the
personal income tax as not being
merely a tax that individuals pay
but one that is also paid by the
single largest share of employertypes in the state.
Conditions have improved somewhat on this score
cannot fully recoup its investment. The optimal deprecia-
in Arizona as of April 2015. Governor Ducey signed
tion schedule, on the other hand, would remain neutral
into law an extension of the conformity on the instant
with respect to the timing of an investment and would,
expensing provisions and its accompanying $500,000
as a result, allow the business to write off the full cost of
limit. However, this still depends on annual federal re-
the investment in the year it’s made.
newal. The sort of expensing provision that would best
13
Policymakers at the federal level came to understand
the problems with the depreciation system and the federal
government did offer what is called “instant expensing”
fit a consumption-tax based regime would be a permanent one.
However, in a state without an income tax, these
for a large category of capital goods (software and used
policy concerns would be moot. Far from being an ar-
vehicles, for instance) starting in 2001, subject to a cap.
cane provision in the tax code, depreciation and expens-
The cap eventually rose to $500,000 in investment per
ing provisions are a critical element to redefining the tax
company by 2014. Tax law changes at the federal level
base to take the current income tax penalty off of invest-
over the past decade and a half also allowed a 50% “bonus
ment and transition to a general consumption base. It
depreciation” of other heavy machinery categories to speed
also eliminates a key distortion created by the income tax
up the write-off schedule and thereby encourage more in-
and keeping such a distortion in a state tax code makes
vestment than would have occurred under the old system.
that state instantly less competitive.
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The treatment of capital gains taxes is also crucial.
would, by definition, remove barriers to the creation of
Taxation of capital gains for stocks and business invest-
new businesses.17 This has ramifications for job-seekers:
ment also impedes crucial investment because it lowers
creation of new firms and the expansion of existing ones
the after-tax rate of return and consequently stifles the
can, by extension, drive further job growth in a state.
supply of new capital. Entrepreneurial activity has been
It’s also no wonder that states which undertake
shown to be sensitive to tax treatment of capital gains:
fundamental tax reform that creates more opportunities
states that allowed more generous exemptions of capital
for investment are also deemed to have a better national
gains from taxation have seen increases in venture capital
reputation as being business-friendly and seen as having
funding to the businesses in their state. Overall em-
a more favorable business climate. For instance, when
ployment growth suffers in states with higher effective
North Carolina started the process of flattening their
capital gains tax rates.15 During the last economic growth
income tax structure and began to transition to a sales-
14
period (2000-2007), the eight states that apply capital
gains taxes at a lower rate had, on average, a 35% higher
net job creation rate than the states that fully tax capital
gains as normal income.16
Arizona has made some strides in capital gains tax
reform. In 2012, the legislature and governor reduced
the tax rate on long-term capital gains on assets purchased after 2011 and held longer than one year. This
was accomplished by allowing an exemption of 15% of
capital gains in 2013 from income taxation. That exemption grew to 25% by 2015, where it will stay unless state
policymakers change it.
While a good step, Arizona still remains less competitive than other states on this score. Current law
amounts to a top effective Arizona tax rate of 3.3% on
capital gains income. New Mexico, on the other hand,
has a top effective capital gains tax rate of 2.85%. And
states that have no income tax, of course, do not have
tax based revenue system over a decade during which
Plenty of data indicate that tax
factors matter in overall business
growth and economic potential
for a state.
the state income tax will be phased-out – a reform that
is very similar to the one suggested later in this study –
their ranking in the Tax Foundation’s State Business Tax
Climate Index jumped to 16th place from its original
perch at 44th place. By contrast, Arizona – despite its
movement on property tax reforms and corporate income tax cuts – has remained at the middle of the pack
at around 23rd.18
TAX REFORM CAN DECREASE REVENUE VOLATILITY
Eliminating the income tax also would decrease
to worry about onerous taxation of capital gains in-
the volatility of state general fund revenue and smooth
come. Finding a way to exempt capital gains income
out the swings over the business cycle. Volatility is
from taxation altogether would be an important goal
measured as the growth rate of revenue relative to the
for any tax reform looking to erase the tax penalty on
growth of the tax base.19 Since revenue volatility is a ra-
investment, and elimination of the income tax is one
tio, when the ratio is much greater than 1, the tax rev-
sure way to do so.
enue is said to be more volatile than the tax base. When
Plenty of data indicate that tax factors matter in
the result is closer than 1, the revenue is considered less
overall business growth and economic potential for a
volatile (i.e., more stable). To put it in straightforward
state. Empirical studies indicate that reforming a state’s
terms: volatility scores are like golf – you usually want a
tax codes to remove the tax barrier to capital creation
lower score.
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Income taxes are notorious for being more volatile
than sales taxes. A 2008 Federal Reserve Bank of Kansas
THE ARIZONA SALES TAX
State policymakers may want to include new revenue
study reported volatility scores for the three major types
sources to replace the income tax when it disappears. It’s
of statewide taxes from 1965 to 2007. The personal in-
worth noting that the single best way to make room in
come tax received a score of 2.58. The corporate income
the general fund budget for any tax reform is spending
tax received a score of 2.61. Meanwhile, sales tax clocked
reform and a commitment to discipline in general fund
in at the least volatile, with a score of 1.24.
budget growth, particularly if it includes a reappraisal of
Within the income tax, there are varying rates of
volatility for particular sorts of income. It’s not surprising, for instance, that corporate income taxes are more
volatile because they are dependent upon the business
cycle and corporate profitability. They grow the fastest in
economic booms but fall the fastest and the furthest in
economic downturns. Capital gains income is also volatile and, as a result, capital gains tax revenues are volatile
as well.20
Historically, it was believed that the structure and
the health of a state’s economy – the industry mix and
what government does well or poorly and making changes to the budget accordingly. Or, to put it another way,
being realistic about what the proper role of government
should be is an important step in all of this.
Eliminating the income tax also
would decrease the volatility of
state general fund revenue and
smooth out the swings over the
business cycle.
the performance of industries within a state – were a
big factor. However, a Rutgers University study in 2011
concluded that when tax structure is taken into account,
revenue volatility was more strongly associated with tax
provisions (such as what is being taxed, what is exempt,
and the rates at which they are taxed).21 It also stands
to reason that tax systems that are based on consumption taxes will tend to have a more stable revenue flow
because consumption is less likely to fluctuate wildly the
way income and profits do.
Arizona has been typical in this respect. As the
Joint Legislative Budget Committee has reported, the
sales tax has been the least volatile revenue source over
the past ten years, tracking Arizona personal income
quite closely. The personal income tax, however, has
As a practical matter, creating new sources of government revenue runs the risk of increasing the tax burden
and rendering income tax reform less economically
powerful. That said, the best option available for revenue
enhancement is through the sales tax system, particularly
since the sales tax is a consumption tax and the best sales
tax systems, when constructed correctly, can embody
many of the attributes of good tax policy outlined in this
study. Therefore, a policy discussion of this sort requires
a look at the current sales tax system to see how it compares to other states. After all, any changes made to the
sales tax system should be considered only in the context
of increasing, not decreasing, Arizona’s competitiveness.
been very “elastic” and more volatile than the sales tax.
The first consideration is the tax rate. As we can see
The corporate income tax has been the least stable rev-
in Table 2, the sales tax rate for the state is currently 5.6
enue stream.22 Thus, eliminating the income tax could
percent, which includes the 0.6 percent Proposition 301
have more than just an economic benefit: it could have
tax to fund education programs. That puts the state’s
the benefit of making the state’s revenue stream more
sales tax rate above most states in the region but below
predictable over the business cycle.
California. Also included in the table are the rates for the
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Center for the Study of Economic Liberty | Policy Report
states that have no income tax and rely largely on sales
between states and helps determine which states have
taxes for much of their revenue. Arizona’s rate is below
narrower tax bases.
five of the seven states in this chart that do not have an
Table 3 lists the number of services (out of a total
of 168 in the FTA master list) that each state taxes. It
income tax.
The rate is only part of the full story. Where much of
indicates that Arizona has a tax base that is broader than
the differences between states exist is the sales tax “base”
Colorado, Nevada, and California. The base, however,
– the goods and services to which the rate applies. States
is narrower than Texas. With the exception of Nevada,
that have a “narrow” sales tax base – meaning they tax a
states that do not have income taxes tend to tax a larger
smaller list of goods – need to have a higher sales tax rate
number of services. (Nevada is an anomaly since much
to generate the same amount of revenue that a state with
of their sales tax revenue comes from a particular set of
an average or low sales tax rate applied to a broader and
taxed services paid for primarily by tourists. Hence, they
less narrow base has.
can get away with a narrower tax base in a way that other
There are a number of commonalities with respect
to sales tax bases. The main one is that most sales tax
states, except tourist destinations like Florida, cannot.)
Note that the states without an income tax and the
systems do not tax food. Of the states in Table 2, the ex-
broadest bases are South Dakota and Washington. New
ceptions are Tennessee, which taxes food at a rate of 5.5
Mexico also has a very broad sales tax base and a lower
percent (less than its normal state rate of 7 percent), and
sales tax rate, but it also has an income tax and a slightly
South Dakota.
lower state sales tax rate than Arizona. Washington taxes
The big differences in the tax bases come in the
many services through its “business and occupations tax”
number of services that are taxed by the sales tax. The
which is functionally a business-based form of sales taxa-
Federation of Tax Administrators (FTA) compiles a list
tion. Finally, it’s worth noting that Florida and Texas have
of what services are taxed in each state and groups them
broader sales tax bases than Arizona, and yet their sales tax
by category. This allows comparisons of sales tax bases
rate is not much higher than the Arizona’s 5.6 percent rate.
TABLE 2
2014 State Sales Tax Rates: Arizona and Its Competitor States
TABLE 3
Number of Services Taxed by the State Sales Tax
State
California
Tennessee
Nevada
Washington
Texas
Florida
Utah
Arizona
New Mexico
South Dakota
Wyoming
Colorado
Sales Tax Rate
7.5%
7.0%
6.85%
6.50%
6.25%
6.00%
5.95%
5.60%
5.13%
4.00%
4.00%
2.90%
Source: Federation of Tax Administrators
10
State
Colorado
Nevada
California
Arizona
Utah
Wyoming
Florida
Tennessee
Texas
South Dakota
Washington
New Mexico
No. of Services Taxed
15
18
21
55
58
58
63
67
83
146
158
158
Source: Federation of Tax Administrators
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Center for the Study of Economic Liberty | Policy Report
Contrasting Arizona and states without an income
comparison that has a relatively narrow sales tax base.
tax, particularly Texas, Washington, South Dakota, and
They are, however, a unique state: close to 40 percent
Wyoming, yields some useful comparisons, particularly
of their revenue comes from severance taxes and royal-
when it comes to services taxed. Table 4 outlines those
ties on mineral, gas, and oil extraction, roughly equal
differences by category.
to the amount they raise in the sales tax.23 Unlike Texas,
States on this side of the country that do not have
which generates only around 11 percent of their rev-
income taxes tend to tax more services than Arizona does
enue from comparable sorts of severance taxes includ-
– in particular, personal services, business services, and
ing those on oil and natural gas, Wyoming can operate
repair services. Each of the other states is able to main-
with such a narrow sales tax base and the absence of an
tain a sales tax rate of 6.5 percent or lower while avoid-
income tax.24
ing the need to institute an income tax. Personal services
The picture that emerges when comparing state sales
are usually things like salon and cleaning services. Busi-
tax bases and the rates that are assessed on them indicates
ness services are things like design, copy, or car services.
that tax policy textbooks are generally correct: states that
Taxation of professional services – like legal, engineering,
have a broad sales tax base can raise sufficient revenue to
and accounting services, for instance – tend to be more
finance state government without an income tax. A poten-
controversial and not frequently taxed. However, they
tial problem with taxing some professional and business
are, indeed, taxed in South Dakota and Washington. In
services, however, is that of “tax pyramiding,” which is a
the latter state they are taxed at a lower rate (1.5 percent)
form of double taxation. This creates double taxation be-
than other services.
cause the taxes on the input costs (the services a business
Besides Arizona, Wyoming is the only state in this
may purchase while they are making their own product)
TABLE 4
Taxable Services (by Category)
Agricultural services
Industrial and mining services
Construction
Utilities
Transportation
Storage
Finance, insurance, and real estate
Personal services
Business services
Computer services
Automotive services
Admissions and amusements
Professional services
Leases
Fabrication, repair and installation
Miscellaneous
Total number of taxable services
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Arizona
1
2
4
12
5
6
0
2
7
0
1
9
0
3
2
1
55
Texas
2
2
3
12
3
2
2
10
14
8
1
12
1
1
10
0
83
South Dakota
4
4
4
14
5
6
7
19
28
8
5
13
5
4
18
2
146
Washington
5
4
4
16
7
6
8
20
33
8
5
13
9
4
16
0
158
Wyoming
0
0
0
10
3
0
0
6
6
2
4
6
0
4
16
1
58
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Center for the Study of Economic Liberty | Policy Report
are collapsed into the price of the final retail good, which
Scenario 1: Eliminating the personal income tax in one
is itself taxed. Any reform that broadens the sales tax base
year.
also needs to address this problem in some way.
Any sales tax reform should also acknowledge the
This is the quickest and cleanest way of eliminating
the income tax. It’s the one that would provide substan-
challenge that city-specific tax rates introduce to the
tial tax relief to Arizona taxpayers. But it’s also the one
competitiveness of the state. Some jurisdictions have
that will require very large spending adjustments to the
sales tax rate add-ons that can catapult the current sales
state general fund since it is not revenue-neutral. Al-
tax rate of their residents to higher than 10%. Any pro-
though the state personal income tax provides less than a
posals to expand the sales tax base should be sensitive to
quarter of total state revenue, it provided nearly $3.5 bil-
this and seek to keep the rate not only regionally com-
lion in general fund revenue for fiscal 2014. This might
petitive but as low as possible.
necessitate spending cuts of up to somewhere between
30% and 36% of the general fund spending baseline.
TAX REFORM SCENARIOS
What follows is a description of five policy scenarios
that could be enacted to eliminate the personal income
tax in Arizona based on the priorities and tax policy principles outlined previously in this study. Each scenario
rests on a couple of important assumptions:
·· Revenue growth over the next decade that, on average, would be the roughly the same as the state
experienced over the last two business cycles.
·· A disciplined annual general fund spending
growth rate of 2.3%.
·· A policy goal of phasing down the income tax as
quickly as possible.
The assumption about maintaining spending disci-
The trade-off would be that more economic growth
would occur as a result of a tax cut of this magnitude.
Doing this would instantly make Arizona much more
competitive against most states, particularly those that
do not have an income tax. The revenue “feedback” that
could occur as a result of the increased economic activity would eventually increase state general fund revenue
collections relative to the new, lower baseline that no
longer includes personal income tax revenue. It would
not, however, eliminate all of the $3.5 billion difference
in revenue.
Also note that the $3.5 billion estimate assumes that
the amount of revenue sharing that the state currently
provides to cities and counties would remain at current-
pline is vitally important. Indeed, it might be the single
law levels. The amount of budget cuts that are needed
most important aspect of any approach to tax reform.
could go down by roughly $600 million if urban revenue
Any large spending increase will either slow down long-
sharing was eliminated at the same time as the income
term tax reform or necessitate large increases in other
tax in the first year. (In subsequent years without a
taxes that will counter and perhaps even overwhelm the
change in current law, revenue sharing that is based upon
beneficial aspects of getting rid of the income tax in the
personal income tax revenues would equal zero because
first place.
the income tax upon which it is based would no longer
exist.)
There are five policy scenarios
that could be enacted to
eliminate the personal income tax
in Arizona.
12
It’s also worth noting that this scenario does not include an elimination of the corporate income tax. Doing
that would add about $400 million to the overall decline
in baseline revenue and would require a commensurate
cut in spending.
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Center for the Study of Economic Liberty | Policy Report
Scenario 2: Phase-out the personal income tax over time
Scenario 3: Eliminate the personal and corporate income
as revenues permit.
tax in one year and make the reform revenue-neutral by
This option would allow a “buy down” of the income tax rates progressively, as revenues permit, over a
reforming the state sales tax.
This scenario would allow the elimination of all in-
long period of time. This scenario doesn’t require supple-
come taxes in one year in a revenue-neutral fashion by
menting current revenue sources or spending cuts. It
either raising the sales tax rate on the existing sales tax
does, however, require strict spending discipline of the
base or increasing sales tax revenue by broadening the
kind described previously and at least normal revenue
sales tax base.
growth.
In order to make up the revenue from eliminating
The idea here is to hold spending to a baseline of no
the income tax in the expedited timeframe of one year
more than a 2.3% growth rate each year – approximately
without broadening the sales tax base, the sales tax rate
the average rate of growth that is estimated through fiscal
2018 in the governor’s January budget proposal.25 Once
spending is under control, step two in this scenario is
to use the resulting surplus—each and every year—to
reduce income tax rates across the board until they reach
zero.
Maintaining spending discipline
might be the single most
important aspect of any approach
to tax reform.
Of all the scenarios discussed in this paper, this
phase-out will take the longest to achieve. Using con-
would need to rise to around 9.6% (a base rate of around
servative assumptions of revenue growth based on the
9% plus the 0.6% rate for education funding per Propo-
historical pattern of the last 15 years, eliminating the
sition 301). When coupled with county and city sales
personal income tax gradually could take more than a
tax rates, the higher sales tax rate could put the average
decade. It would take longer than that if the corporate
Arizona tax rate to over 11% (and, in some locations,
income tax is included in the phase-out. During that
over 13%), making it the highest sales tax rate in the na-
time, it is probable that at least one recession will occur,
tion by a large margin and nearly twice as high as many
which could derail the buy-down of the income tax rate
of our competitor states. For instance, it would put our
until after the recession. There are also higher risks of
average state and local sales tax rate higher than Texas,
political pressure leading to an increase in the income
twice the sales tax rate of Utah, and even higher than
tax rate again to a previous level to balance the budget.
California.26
Additionally, these gradual and relatively small rate
The other option would be to broaden the sales tax
cuts are not likely to spur much new economic growth,
base to some services. As explained earlier in this study,
especially if there isn’t a firm political commitment to
Arizona has a relatively narrow sales tax base when com-
maintain the income tax rate reduction until the rate
pared to some other states that currently have no income
reaches zero.
tax. Expanding the base to apply the sales tax to a num-
On the other hand, a more aggressive scenario to en-
ber of professional, business and personal services could
sure spending discipline and a buy-down of the income
help make the elimination of the income tax revenue-
tax rates could entail reform of the urban revenue sharing
neutral.27
system (see Scenario 4 for details) and spending cuts or
freezes.
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However, it’s important to make sure that the expansion of the sales tax base does not lead to taxing business
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Center for the Study of Economic Liberty | Policy Report
inputs or lead to other forms of double taxation. This is
an income tax. Expanding the sales tax base in this way
especially important if policymakers look to eliminate
might only require a state sales tax rate of around 6.6%
the personal income tax but not the corporate income
which, when coupled with the Proposition 301 add-on
tax. The corporate tax, because it’s based on profits that
rate, would require a total state sales tax rate of 7.2% to
include sales receipts from items taxable by the sales tax,
make a one-year elimination of the personal income tax
would effectively tax the same dollar or economic activity
revenue neutral.28 The rate would go down, however,
twice.
if the sales tax base were expanded further than is pro-
Exempting business inputs at the wholesale level is
posed here.
already done in Arizona. Each business uses their business tax ID number in business-to-business transactions
Scenario 4: Institute a flat income tax in the first year,
and is not required to pay taxes on those transactions as
then phase-out the personal and corporate income tax
a result. Taking the same approach for business services
over six years and achieve revenue-neutrality through
that are part of business-to-business transactions — legal
reforms to the sales tax and/or other revenue generating
services and accounting services, for example—would
options.
eliminate the hidden double taxation while expanding
This scenario combines a gradual approach of phas-
the sales tax to final-use, end-user services that are pur-
ing out all income taxes, while simultaneously enacting
chased by individuals.
a number of beneficial reforms to the state tax code that
can maximize economic growth while the income tax
It’s important to make sure
that the expansion of the sales
tax base does not lead to taxing
business inputs or lead to other
forms of double taxation.
sunsets. To do so would require two components: 1)
Replacing the current five-tier personal income tax with
a flat-rate income tax in the first year that makes most
taxpayers no worse off and includes permanent instant
expensing allowances for small- and medium-sized
businesses; 2) Begin a transition to a greater general
fund reliance on sales tax revenue and require the sales
The reform option outlined here assumes that the
state could expand the system currently in use for exempting wholesale purchases intended for resale to the
tax base of cities to be made consistent with the new
state base.
The spending discipline and paired with a transition
taxation of services. In such a framework, business input
to a broader-based sales tax would allow a “buy down” of
transactions for services can be declared as exempt when
the personal and corporate income tax rate each year un-
the company remits sales tax receipts to the state.
til it reaches zero. The buy down of the income tax rates
With that in mind, the number of personal and
would occur at a speed contingent upon revenue growth
business services that are taxed could be expanded in
during the fiscal year (assuming a firm commitment to
Arizona without becoming less competitive with other
budget discipline that holds general fund spending to
states and our regional neighbors, which would allow
around 2.3%). Estimates based on observed fiscal history
a less steep increase in the sales tax rate than would
and conservative assumptions about future economic and
be required otherwise, but still higher than might be
revenue trends indicate that the personal and corporate
advisable for the purposes of regional competiveness
income taxes could be phased-out in this manner within
or relative to the average sales tax rate of states without
five years.
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Component 1: A flat-rate income tax to take the place
around 4.1%. This would ensure that almost everyone
of the current income tax that would eventually be phased
pays no more taxes than they did before. Those at the
out. The first step of this scenario is to collapse the cur-
lower end of the income spectrum would receive a tax
rent five-tier income tax structure into a single rate “flat”
cut due to the generosity of the new zero bracket. Those
tax. However, unlike some versions of the flat tax, this
in the middle- to upper-end of the income spectrum
one will not eliminate all exemptions or deductions or
would receive a tax cut due largely to the lower rate. (See
tax credits. (For a discussion of what to do about tax
Table 5 for context.)
credits, see Appendix B.) It will keep the existing de-
Another element that should be integrated into this
ductions and exemptions, including mortgage interest
new exemption system is a permanent “instant expensing”
deduction, the charitable contribution deduction, and
provision. This would allow all businesses that pay taxes
the medical expenses deduction. It also would keep the
through the income tax system to write-off immediately
existing tax credits.
the full value of any capital investment they make in
Instead, this one-rate income tax plan would increase
their business.30 This could be capped at the current limit
the “zero bracket” below which income is exempt from
($500,000, which would cover most of the investment
taxation. It could do so by creating a single per-person
done by a small- or medium-sized business each year) and
exemption at the same dollar amount per person in a
indexed for inflation. This would, by definition, further
household. The per-person amount that creates the zero
redefine the income tax as one that more closely approxi-
bracket could actually be broader than the current one
mates a consumption tax than an income tax. The same
and be based on the poverty line in Arizona.
goes for exempting capital gains income completely from
For instance, the current income tax system relies
the income tax base, which could be done in this flat tax
on a standard deduction ($4,945 for a single filer and
plan. Both of these moves, when coupled with the single
$9,883 for joint filers) and a personal exemption ($2,300
per child dependent and $6,300 per married couple).
So, the current “zero bracket” for a family of four in this
example is $20,783. In the flat tax proposed here, the
bracket would be based on the poverty line in Arizona
(currently at $23,850 for a family of four) and would essentially be a per person exemption of $5,962. Therefore,
a family of four would be start with a “zero bracket” of
$23,848. This bracket would apply to the income of all
29
families. Anyone with taxable income in Arizona would
not be hit with the income tax until its income exceeded
the zero bracket.
The personal income tax rate could then be determined based on the needs of the general fund in the
short-term while also acknowledging a desire to make
tax rate, would likely provide substantial economic growth
potential for the state and set a strong foundation for
future economic and revenue growth that will be used to
ratchet-down the income tax rate over time.
Implementing reforms that make nobody any
worse off than under the current system would result
TABLE 5
A Flat-Rate Tax for Arizona (brackets by taxable adjusted
gross income)
Old System (single filer)
$0–$10K
$10K–$25K
$25K–$50K
$50K–$150K
$150K and over
2.59%
2.88%
3.36%
4.24%
4.54%
New System
$0 and over
4.10%
sure that everyone is no worse off under the new system
and, in the best case scenario, might even see a small
tax cut. The rate that balances each of these concerns is
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Center for the Study of Economic Liberty | Policy Report
in an income tax cut (relative to the baseline) estimated
the top income tax rate for both the personal income
at around $362 million in the first year. The rate can
tax and the corporate income tax. To give taxpayers and
be raised slightly to neutralize this, but the 4.1% was
businesses time to adjust to the new tax rate and sales
estimated to both achieve a target as close to revenue-
tax base, the new sales tax base and rate can be activated
neutrality as possible and also shield as many taxpayers as
during the second year of the tax reform. By that point,
possible from a tax increase.
the top income tax rate could be less than half of what it
In later years, the income tax rate can be cut by
either a set amount each year or made contingent on a
revenue “trigger.” The trigger could be tied to the rate of
is today (from 4.54% to around 2.0%) by the time the
new sales tax rate is in place.
The best approach, for the purposes of maximizing
revenue growth and as long as a revenue growth target
the economic impact of the reform, would be to commit
is met each year, the minimum income tax rate “buy
to a minimum buy-down of the income tax rate each
down” kicks in. Another option would be to commit a
year. Forward-looking businesses need the security of the
specific share of the supplemental revenue (described in
consistent and downward trajectory of income tax rates
“Component 2” below) not to new spending but to ex-
so they can feel safe making long-term investments that
clusively cutting the income tax rate each year.
will yield the most economic growth.
Year two of the reform (FY 2018) could see the big-
Component 2: Changes to the sales tax system. To
gest single-year reduction in income tax rates. That’s
safeguard the “buy-down” of the income tax rate over
because most of the increased sales tax revenue from the
time and to make sure the state general fund has a steady
expansion of the sales tax base can go to buying down
source of general fund revenue that is more heavily based
the income tax rate by as much as possible in that first
on consumption taxation instead of income taxation,
year. Doing less than that would increase the overall tax
either a broadening of the sales tax base (along the lines
burden for Arizonans.
of what was outlined in Scenario 3) or an increase in the
Note that while the broadening of the sales tax
sales tax rate could be enacted. If the sales tax base were
base (or, alternatively, an increase in the sales tax rate) is
broadened in the way described above – to a number of
mainly designed to be a mechanism to achieve revenue
professional, business and personal services that
are currently not subject to the sales tax – then
CHART 1
Income Tax and Sales Tax Rate Schedule
the sales tax rate would likely not need to be
more than 6% (5.4% plus the Proposition 301
tax rate).31 If the sales tax base were not broadened, then the total state sales tax rate would be
7.4% (or, in other words, the base state sales tax
would be 6.8% plus the 0.6% Proposition 301
rate). For the sake of keeping the sales tax rate
competitive both nationally and regionally, an
overall 6% rate would be preferable.
The sales tax rate and income tax rate phasedown schedule is depicted in Chart 1. The line
represents the sales tax rate. The bars represent
16
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Center for the Study of Economic Liberty | Policy Report
neutrality, other options still exist to meet that goal.
of urban revenue sharing that the state commits will be
One could be to increase the amount of money the state
capped at fiscal year 2017 levels even after the income
collects in certain user fees, such as vehicle license fees.
tax is phased out. At least a third of the new revenue that
Another would be to cap or reduce the amount that the
comes from expanding the sales tax base goes to maintain
state spends on homeowner property-tax rebate. If these
current levels of urban revenue sharing. In addition, the
types of revenue options are pursued, the amount that
sales tax expansion will increase the amount of overall state
has to be raised by the sales tax could be reduced. Nei-
revenue shared by the state with localities via the current
ther of these options should be used to increase spend-
sales tax revenue sharing laws (in which they receive 25%
ing but should instead go directly to phasing down the
of state sales tax collections). As a result, the amount of
income tax.
money that cities and counties receive could go up relative
Note also that the estimates here suggest an average
to current law. If changes are made to current law to take
rate reduction each year (after year two of the reform
this account, the sales tax rate may not have to be as high
plan outlined here) of roughly half a percentage-point
to maintain revenue sharing. However, if revenue sharing
each year. However, to address budget concerns, the buy-
reforms are considered (as they are in Scenario 5), a sales
down of the income tax rate could be, starting in year
tax base expansion may not even be necessary or at least
three, tied to a revenue trigger. If, for instance, revenue
not in the magnitude estimated here if keeping the current
does not grow as fast as the general fund budget baseline
revenue sharing system intact is not a goal.
of 2.3%, the buy down in that year can be reduced for
that one year. Another way to tying the buy down to revenue flow would be to pre-commit a portion of the increased sales tax revenue to buying down the income tax
rate. The estimates here suggest that between 20% and
30% of the new sales tax revenue from taxing services
can be committed to the income tax rate reduction each
year without upsetting the 2.3% growth rate of general
fund spending or the six-year phase-down.
An important part of this reform is a state mandate
For the sake of keeping the
sales tax rate competitive
both nationally and regionally,
an overall 6% rate would be
preferable.
Scenario 5: Commit to a maximum eight-year phasedown of the personal income tax to be achieved through
that cities must differentiate themselves on sales tax rates
spending reforms to budget items such as the urban rev-
alone, not on carve-outs to the sales tax base as they often
enue sharing program.
currently do. A requirement that the sales tax bases must
The scenarios above have mostly assumed that mak-
be uniform across jurisdictions should be enacted. For
ing room in the state budget for “buying down” income
example, if food is not taxed at the state level, it cannot be
tax rates would largely come from increases in sales tax
taxed at the local level either. Texas has this requirement
revenue. However, there is another way. State policymak-
and it is, as a practical matter, one of the things that make
ers could commit to no more than an eight-year phase-
their sales tax system much less complex than other states.
down of the income tax without raising the sales tax rate
North Carolina, which has reformed its tax system along
or expanding the sales tax base. State policymakers could,
lines similar to what is proposed here, also has made a uni-
in addition to keeping general fund budget growth rate
form local sales tax base a requirement.
at no more than 2.3% each year, also enact reforms to
Finally, note that this scenario assumes the amount
May 12, 2015 | No. 2015-01
spending programs. They could start with reforms to the
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Center for the Study of Economic Liberty | Policy Report
urban revenue sharing program and use those savings to
income tax rate reduction. An alternative criterion would
reduce the income tax rate.
be to lower the amount of shared revenue for cities that
In the first year, policymakers can enact the flat tax
proposal outlined in prior scenario. Then, based on the
already have a high tax burden.
The cities would continue to have the flexibility
strength of economic growth and budget savings from
under this reform to raise the local sales tax rate con-
reforming revenue sharing, the income tax rate could be
tingent on state law (which requires ballot approval).
lowered each year by at least half a percentage point until
As a result, this reform would also give local taxpayers
it reaches zero in year eight (FY 2025).
more control over the size of government in their cit-
The first reform that should be made to revenue
ies. If city policymakers want to finance an increase in
sharing is to decouple it from the income tax by mak-
the city budget in a fiscal year that would have been
ing it part of the general fund appropriation process and
financed otherwise by state-shared revenue, they need
ending the automatic deferral of income tax revenue
to ask for the money back from taxpayers instead of
away from the general fund. Making this program part
receiving that portion of money automatically from the
of the appropriations process, just like a typical govern-
state government.
ment program, would mean that it would be competing
The income tax phase-out could be hastened by
with general fund resources just like other programs
further budget savings in other programs. A good tar-
must. To justify the expense, cities would need to at least
get might be the revenue transfers that currently fund
prove they are wisely using the money the state is sharing
the Arizona Commerce Authority (ACA), which cur-
with them. Policy accountability metrics could also be
rently amounts to around $53 million. Eliminating the
tied to the shared revenue as a condition of receiving it.
income tax would be a very substantial leap forward
Nor would the legislature necessarily need to keep
the overall level of revenue sharing constant. In fact,
in terms of economic competitiveness and it’s very
unlikely that the economic potential that would result
keeping the current level of revenue sharing would likely
require budget cuts in other general fund programs. If
the legislature believes that cities, particularly wealthier
cities that already receive a large portion of shared revenue because they have a large population, could raise
An income tax phase-out could
be hastened by further budget
savings in other programs.
the revenue and make the spending program reforms
necessary to finance city budgets on their own, that
from income tax elimination could ever be matched
would be the prerogative of the legislature. They may de-
by any ACA-driven industry favoritism or activity they
cide to avoid program cuts to other programs and reduce
currently undertake. Besides, one of the current roles of
the amount of urban revenue sharing. They also could
the ACA is to administer various and sundry tax credits
introduce a “means-test” to the urban revenue sharing
that would disappear in a reform that phases-out the
formula wherein large cities with robust tax bases get less
income tax over time (see Appendix B). Therefore, the
or no revenue sharing money while small, rural cities
role of the ACA could be streamlined and reduced in
with a less robust tax base would be held harmless. Mak-
the process of phasing out the income tax and, as a re-
ing such a policy change could potentially save the state
sult, so could their budget.
around $400 million each year relative to the current-law
baseline and those savings could help pay for each year’s
18
Other general fund budget programs could be reformed – and wasteful spending within them targeted
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TABLE 6
Tax Reform Scenario Summary
Scenario 1
Scenario 2
Scenario 3a
Scenario 3b
Scenario 4a
Scenario 4b
Scenario 5a
Scenario 5b
* Not revenue neutral
Timeframe
(years)
1*
10+
1
1
6 to 7**
6 to 7**
7 to 8**
6 to 7**
Personal or Corporate
Income Tax Eliminated?
Both
Personal only
Both
Both
Both
Both
Both or personal only
Personal only
State Sales Tax
Rate (total)
5.6%
5.6%
9.6%
7.2%
7.4%
6.0%
5.6%
6.6%
Sales Tax Base
Broadened?
No
No
No
Yes
No
Yes
No
No
Changes to
Revenue Sharing?
No
No
No
No
No
No
Yes
Yes
** Assumes flat income tax reform in year one
– to provide budget savings to speed up the phasedown
however, should only be temporary and the ballot lan-
of the income tax rate. A reappraisal of the scope of state
guage should be specifically worded to indicate that most
government and scaling it back to a smaller role than it
or all of the new revenue would go exclusively to buy
currently plays could also yield substantial budget savings
down the income tax rate and that it will sunset after the
that could be put toward tax reform.
income tax rate reaches zero or seven years has passed,
The corporate income tax could be phased out in a
whichever is sooner.
fashion similar to that proposed in prior scenarios. That
would require additional budget savings averaging around
$58 million each year. In the absence of savings in that
amount, an extra year or two of tax rate phase-out could
accomplish the same goal. However, the usual cautionary
note about the potential for another business downturn
over this longer time-horizon should be heeded.
Finally, policymakers may still deem in necessary to
augment sales tax revenue. However, instead of expanding
CONCLUSION
The best hope Arizona policymakers have to eliminate
the income tax is to phase it out over a number of years
while maintaining budget balance. The speed of how fast
the income tax rate can fall will depend critically on how
strictly state policymakers adhere to spending discipline
and to how fast revenue and the economy grows.
The best time to consider fundamental tax reforms
the sales tax base to services, another option that might
is when a state is on surer fiscal footing. Now that the
be worth pursuing (and would likely have fewer politi-
state government has reached a semblance of genuine
cal challenges than expanding the sales tax base) is a sales
structural balance for the first time since the recession,
tax rate increase of no more than one cent on the existing
it’s incumbent on Arizona policymakers to take a look at
sales tax base. That could, when paired with the spending
important and necessary reforms over the next couple of
reforms outlined here, potentially speed up the personal
years. As the state prepares to face a new era of economic
income tax phasedown to no more than five or six years.
growth and the tax competition between states that has
Because the sales tax rate would increase if this path is
been occurring in earnest for decades, waiting longer
chosen, voter approval is required. The sales tax increase,
may result in losing a golden opportunity.
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Center for the Study of Economic Liberty | Policy Report
APPENDIX A
METHODOLOGY
mates are explained in more detail below.
that is reliant on the income tax (both personal and corporate). As you can see, the general trajectory of general
fund revenue can remain intact as the revenue stream
transitions to greater reliance on the sales tax.
Revenue estimates
Taxable income growth estimate
The estimates in this study use publicly-available
data and are based on assumptions about the future that
take into account the fiscal history of the state. The esti-
Revenue estimates for all taxes for fiscal year 2017 and
2018 are based on data from the Office of Strategic Planning and Budgeting in its January 2015 budget summary.
The estimates within that document are based on analysis
by the L. William Seidman Institute at Arizona State University. The projected growth rates of future revenue are
annualized averages that are based on estimates for fiscal
2014 through fiscal 2018 from this same document.
Annual growth estimates for base sales tax revenue
years after fiscal 2018 are an historical average based on
The estimates of taxable income growth past fiscal
year 2018 are an average of prior year trends based on
historical taxable income growth as published by the Department of Revenue (DOR) in their annual publication,
“Individual Income Tax Statistics.” The data provided by
DOR is lagged by a number of years (the most recent is
for tax year 2010), so the income tax data was scaled-up
to the present day, using an average based on annualized
growth rates from the prior seven years, for the purposes
of the analysis.
data from the Joint Legislative Budget Committee. The
average is derived from the growth rate already experi-
Sales tax base estimate
enced during the last business cycle period (1999-2007).
Estimates of the revenue expected from expanding
the sales tax base to services were based on the Depart-
The growth rate assumed in the estimates in the study
is around 7.7% each year. It should be
noted that the period upon which the av- CHART 2
erage is based included at least two years
Income Tax and Sales Tax Rate Schedule
of unusually low revenue growth. Taking
out those two years brings the average
sales tax revenue growth rate to just over
10%. Therefore, the 7.7% average used
in this study is potentially conservative
for the timescale addressed in this study.
For the purposes of illustration, the
growth rate of general fund revenue, net
of the “buy down” of the income tax, is
right around 2.3%. Chart 2 depicts the
growth of general fund revenue that is
spendable by the government as well as
the percentage of general fund revenue
20
Source: Author’s calculations.
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Center for the Study of Economic Liberty | Policy Report
ment of Revenue’s publication, “The Revenue Impact
of Arizona’s Tax Expenditures: Fiscal Year 2013/2014,”
November 15, 2014. To estimate the portion of annual
transactions that would be exempt because of the need to
keep business-to-business transactions tax-free, an Ernst
and Young study, prepared for the Council on State
Taxation (COST), was used. (“Sales Taxation of Business
Inputs,” by Robert Cline, John Mikesell, Tom Neubig,
and Andrew Phillips, January 25, 2005.)
As a result of the proposal to exempt business-to-
TABLE A
Portion of Business Services Category Due to Business-toBusiness Transactions
Professional, Scientific, and Technical Services
Administrative and Business Services
Financial Services
50.6%
32.8%
66%
Source: Author’s calculations based on data from COST and the Arizona
Department of Revenue
A note on Proposition 301
Expanding the sales tax could also increase the sales
business transactions, the estimates of potential revenue
tax base to which the Proposition 301 sales tax rate is ap-
gains from expanding the sales tax base generated by the
plied. Doing so could generate at least $160 million each
Arizona Department of Revenue are larger than what can
year for Proposition 301 programs. Because that revenue
be expected under a tax system that exempts from sales
stream would be automatically re-routed to voter-ap-
taxes the purchase of services that are not to a final-use
proved education programs, that increased revenue was
consumer. Based on the COST study, estimates of the
excluded from overall growth of government estimates
percentage of the three major business service categories
used in this paper. If included, overall education-inclu-
that is composed of business-to-business transactions ap-
sive state spending would actually grow faster than the
pear below in Table A.
2.3% estimated in this study.
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Center for the Study of Economic Liberty | Policy Report
APPENDIX B
WHAT ABOUT INCOME TAX CREDITS?
There are a number of tax credits that are attached to
gating tax burdens on the poor: the tax credit to com-
the existence of the personal income tax. The disappear-
pensate for increased excise taxation (A.R.S. § 43‐1073)
ance of the income tax would obviously have an impact
and the working poor family tax credit (A.R.S. §
on them. Thus, it is important to consider what reforms
43‐1072.01). The former was enacted when the 0.6%
might be necessary and desirable for those programs and
sales tax rate was added after the passage of Proposition
whether those credits are worth keeping in the future. In
301 in 2000 for the purposes of financing more educa-
addition, it should also be remembered the elimination
tion spending and was designed to help poor families
or reform of some of these credits could yield budget sav-
who were now paying a higher sales tax burden because
ings (relative to the baseline) that could help state gov-
of the new higher rate. The latter, which is a credit
ernment make the transition to the new tax system and
that can be claimed only by a tax filer family at below
those savings should be considered in any discussion of
$31,000 ($10,000 for single filers) in federal adjusted
whether to keep the credit.
gross income, is primarily a way to help poor families
For starters, by far the largest income tax credit is
aimed at allowing tax filers to recoup some of the taxes
working their way out of poverty.
These income tax credits are best described not as
they paid to other states and countries. The state awards
discrete credits but as part of an overall welfare pro-
over $90 million in those credits annually. These credits
gram administered by the state. What makes them
are meant to help taxpayers subtract out of their tax bill
peculiar is that they are administered through the tax
the out-of-state income that is included in their taxable
code and not through the general fund the way other
base (i.e., federal adjusted gross income) but should not
welfare spending is. However, the elimination of the
be subject to tax by the state of Arizona. That this credit
income tax doesn’t necessarily have to make the poor
would disappear if the income tax were to be eliminated
worse off relative to the status quo in which the in-
should not be a concern. The problem the tax credit was
come tax and these credits still exist. As we’ve seen, any
designed to remedy is a problem created entirely by using
shift away from the income tax can be structured in
income as the basis for taxation. In a consumption-based
such a way as to avoid hurting poor workers. And, as
tax system, where the income was earned or to what
discussed previously, such a push to eliminate income
external governmental entity a tax was paid based on it
taxation should be seen as a way of setting free cur-
would be irrelevant. Instead, taxation would be based on
rently pent-up economic growth potential and could
in-state consumption only.
therefore increase the number of new job opportunities
There are, however, a number of other income tax
for poor workers. Additionally, folding this form of
credits that tax filers can take advantage of to lower their
financial support for the poor back into the yearly bud-
income tax liability. These tax credits fall into four differ-
get appropriation process instead of relying upon the
ent categories and are discussed below.
auto-pilot nature of the current tax credit regime could
increase the transparency and accountability of all the
Tax credits for the poor
Two credits – which together account for nearly
$40 million in tax credits awarded – are aimed at miti22
funds being spent by state government to alleviate poverty in the state and potentially lead to more effective
outcomes overall.
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Center for the Study of Economic Liberty | Policy Report
Property tax credit
This tax credit is designed to lower the overall cost
ing are the ones that are meant to subsidize the creation
of new jobs. There is no evidence that they actually cre-
of property taxes by lowering the overall income tax bill
ate new jobs, on net, that wouldn’t have been created
owed by low-income elderly homeowners. It amounts to
otherwise. As a result, these tax credits simply represent a
roughly $7 million a year, or just over $380 per claimant.
transfer of wealth from taxpayers to businesses for doing
Yet, it’s not clear that lowering income taxes for home-
things those businesses would have done anyway.
owners is the best way of lowering overall property tax
The credits aimed at subsidizing research and devel-
burdens. Lowering property tax burdens directly is likely
opment would also not have a place in an environment
to be the best way.
where there is no income tax. The initial aim of these
The argument in favor of this tax credit has to do
credits was to provide additional support for a specific
with the fact that piggybacking on the income tax form,
corporate investment – R&D – that was being penalized
which already requires a statement of a filer’s income
within an imperfect income tax regime. But when all
level, is an easy way to means-test this form of tax relief.
non-consumed business income that is invested would be
However, alleviating the tax bill of poor elderly home-
exempt from taxation – including those that are invest-
owners could easily be done through the property tax
ments in research and development – having an R&D
system itself in a world without an Arizona income tax.
tax credit is unnecessary.
Means-testing could still be accomplished by allowing a
Finally, business-activity credits of all sorts are often
poor elderly homeowner to prove eligibility by submit-
justified as enticements to businesses outside the state
ting to the county a federal income tax statement that
that might consider relocating to Arizona. However, tell-
shows their adjusted gross income. A tax credit could
ing businessmen in other states that Arizona no longer
then be applied directly against the property taxes owed.
has a personal income tax is a much better recruitment
This might increase slightly the administrative costs of
tool than any particular tax credit. The benefits of using
local governments, but it is likely to be a small increase
these tax credits as deal sweeteners virtually disappears
and could even be a cost that is shared between state and
when there is no personal income tax for those businesses
local government.
to contend with.
Tax credits designed to spur job creation and
Education-related tax credits
other specific behaviors
Unlike most of the other tax credits discussed here,
Most of the remaining tax credits are ostensibly
the education tax credits are worth finding a way to sal-
aimed at subsidizing specific business decisions or other
vage. There are two main types of tax credits that lower
behavior, such as installing residential solar panels. It’s
the tax liability dollar-for-dollar (up to specific dollar
hard to rationalize keeping these types of credits. They
limits) for income tax filers who give a donation to either
are mostly the product of trying to steer private invest-
a public school or a non-profit organization. The first is a
ment in a specific direction, thereby creating the eco-
credit for donations to a scholarship tuition organization.
nomic distortions that are the hallmark of most income
The STO, in turn, uses the money donated to give out
tax systems. If the goal of tax reform is to both reduce
scholarships to special needs children to attend private
economic distortions and eliminate the taxation of in-
schools or receive specialized homeschooling attention.
come, these credits should not be salvaged.
The other type of tax credit is geared to those who con-
The credits that are particularly hard to justify keepMay 12, 2015 | No. 2015-01
tribute money to public schools to help fund various
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Center for the Study of Economic Liberty | Policy Report
extracurricular programs. In fiscal year 2012, the most
recent year of data available, personal income tax filers
declared a total of roughly $116 million in these credits
($64 million for the STO credit and $52 million for the
public school credit). That’s the biggest overall chunk of
all the existing personal income tax credit categories.
The donations that trigger these credits are best seen
as a private source of funding for expenses that, in the
absence of the donations, would have to be financed by
the state government or the school district. So, unlike
other tax credits that are meant to subsidize activities,
these credits are more properly thought of as reimburse-
24
ments for people who used money they would have paid
in taxes otherwise and directed it instead to a specific
public service. This, by definition, frees up room in the
budget of those respective governmental entities and the
credits are a way of taking some of that surplus and delivering it back to taxpayers.
Yet, property taxes pay finance the vast majority of
school budgets so it’s peculiar to administer this program
through the income tax. So, in a world in which there
is no income tax, state law should be changed to allow
property tax payers to declare the same credit against
their property tax liability.
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Center for the Study of Economic Liberty | Policy Report
ENDNOTES
1 Jeremy Duda, “Income tax cuts emerge as key issue in
AZ GOP gubernatorial race,” Arizona Capitol Times, June 3,
2014. Available at: http://www.arizonatax.org/news-article/
income-tax-cuts-emerge-key-issue-az-gop-gubernatorial-race.
2 The final report, minutes, and accompanying material
related to the Arizona Legislature Joint Task Force on Income
Tax Reform proceedings is available at: http://www.azleg.gov/
itr/default.asp. The author of the current study served on this
task force and some of the material discussed here was developed for and during the task force proceedings.
3 For an extensive review of the literature, see William
McBride, “What is the Evidence on Taxes and Growth?” Tax
Foundation Special Report No. 207, December 18, 2012,
available at: http://taxfoundation.org/article/what-evidencetaxes-and-growth.
4 Calculations based on U.S. Census Bureau data by Tax
Foundation: http://taxfoundation.org/article/arizonas-stateand-local-tax-burden.
5 Joint Legislative Budget Committee Tax Handbook,
“Historic Tax Law Changes,” available at http://www.azleg.
gov/jlbc/13taxbook/13taxbk.pdf and http://www.azleg.gov/
jlbc/13taxbook/iit.pdf.
6 Thomas Dye and Richard Feiock, “State Income Adoption and Economic Growth,” Social Science Quarterly 73, vol.
3 (1995): 648–54; Barry W. Poulson and Jules Gordon Kaplan,
“State Income Taxes and Economic Growth,” Cato Journal 28,
no. 1 (winter 2008): 53–71, http://www.cato.org/pubs/journal/
cj28n1/cj28n1-4.pdf; and “State Economic Prosperity and Taxation,” by Pavel Yokovlev, Mercatus Center Working Paper No.
14-19, July 2014, available at: http://mercatus.org/publication/
state-economic-prosperity-and-taxation.
7 See literature review sections of this Anderson Economic Consulting report and, in particular, the analysis
of the Tax Foundation’s “Business Tax Climate Index.”
http://www.andersoneconomicgroup.com/LinkClick.
aspx?link=upload%2fDoc1950.pdf&tabid=125&mid=411.
8 According the Minnesota Center for Fiscal Excellence,
Phoenix and Tucson have industrial property tax burdens that
rank them within the top 16 nationally. Compared to residential property tax burdens, commercial property tax burdens
in Phoenix and Tucson are substantially higher. For instance,
industrial property valued at $100,000 could actually have a
property tax burden over twice the size of a residential propMay 12, 2015 | No. 2015-01
erty that is valued higher ($150,000). For standard commercial
property, the difference for the same set of valuations is over
70%. See http://www.lincolninst.edu/subcenters/significantfeatures-property-tax/upload/sources/ContentPages/
documents/Pay_2012_PT_%20Report_National.pdf.
9 See Joint Legislative Budget Committee Tax Handbook
2014, http://www.azleg.gov/jlbc/14taxbook/14taxbk.pdf.
10 A good summary of the basic issues surrounding corporate tax incidence appears in Bruce Bartlett, “Who Pays the
Corporate Income Tax?” Economix blog, New York Times, February 19, 2013, available at: http://economix.blogs.
nytimes.com/2013/02/19/who-pays-the-corporate-incometax/. There is evidence that labor bears most of the cost of corporate taxation, particularly at the state level, because capital
is more mobile than labor and can flee high-tax jurisdictions
more easily. See testimony by Dr. Kevin Hassett, American
Enterprise Institute, to before the Joint Economic Committee,
U.S. Congress, April 17, 2012, available at: http://www.jec.
senate.gov/public/index.cfm?a=Files.Serve&File_id=a3c28459af3c-430e-a7e7-3547bd634fe4.
11 See Joint Legislative Budget Committee Tax Handbook
2014, http://www.azleg.gov/jlbc/14taxbook/14taxbk.pdf.
12 See Small Business Administration state profile for
Arizona, available at: https://www.sba.gov/sites/default/files/
advocacy/AZ_1.pdf.
13 For a technical explanation of the benefits of instant
expensing, see Arthur Hall, “Expensing: A Competitive Leap
for Kansas Tax Policy,” Technical Brief 07-0903, University
of Kansas Center for Applied Economics, September 2007,
available at: https://business.ku.edu/sites/businessdev.drupal.
ku.edu/files/images/general/Research/TB%2007-0903-Expensing%20(Hall).pdf.
14 Paul A. Gompers and Paul Lerner. “What Drives
Venture Capital Fundraising?” National Bureau of Economic
Research Working Paper no. 6906, January 1999, available at:
http://www1.hbs.edu/research/facpubs/workingpapers/
papers2/9899/99-079.pdf; and William Gentry. “Capital
Gains Taxation and Entrepreneurship.” American Council on
Capital Formation, November 2010. Available here: http://
www.accf.org/publications/142/ capital-gains-taxation-andentrepreneurship.
15 Ike Brannon, William Melick, and Eric Andersen.
“Employment Effects of Reducing Capital Gains Tax Rates
25
Center for the Study of Economic Liberty | Policy Report
in Ohio.” American Action Forum, June 2011, available at:
http://americanactionforum.org/sites/default/files/capgainstaxoh-draft%20to%20post.pdf.
16 Stephen Slivinski, “Unlocking Entrepreneurial Forces:
States Can Spark Business Creation, Attract Venture Capital
Investment, and Increase Job Growth by Eliminating Taxation
of Capital Gains,” Goldwater Institute Policy Brief No. 12-01,
February 29, 2012, available at: http://www.realclearmarkets.
com/blog/Policy%2520Brief%2520022912%2520Cap%2520
Gains_0.pdf.
17 See “State Economic Prosperity and Taxation,” by
Pavel Yokovlev, Mercatus Center Working Paper No. 14-19,
July 2014, available at: http://mercatus.org/publication/stateeconomic-prosperity-and-taxation.
18 Scott Drenkard and Joseph Henchman, 2015 State
Business Tax Climate Index, Tax Foundation, October 28,
2014, available at: http://taxfoundation.org/article/2015-statebusiness-tax-climate-index.
19 For a discussion of the empirical literature and insights
on revenue volatility, see “State Tax Revenue Forecasting Accuracy: Technical Report,” by Donald J. Boyd and Lucy Dadayan, Nelson A. Rockefeller Institute for Government, State
University of New York, September 2014, available at: http://
www.rockinst.org/pdf/government_finance/state_revenue_
report/2014-09-30-Revenue_Forecasting_Accuracy.pdf.
20 Dennis Hoffman, “Capital Gains in Arizona and the
Effect on State Government General Fund Revenues,” Report
from the Office of the University Economist, Arizona State
University, available at: https://wpcarey.asu.edu/sites/default/
files/uploads/research/competitiveness-prosperity-research/
Capital-Gains-Final.pdf.
21 Sunjoo Kwak, “Revenue Volatility: The Determinants
and Consequences,” Rutgers University dissertation, October
2011, available at: https://rucore.libraries.rutgers.edu/rutgerslib/35881/.
22 Joint Legislative Budget Committee, “Volatility of Major
Revenue Sources,” September 2, 2014, available at: http://www.
azleg.gov/jlbc/volatilityofmajorrevenuesources.pdf.
23 See “Wyoming State Government Forecast, Fiscal Year
2015 - 2020,” January 2015, State of Wyoming Consensus
Estimating Revenue Group, available at: http://eadiv.state.
wy.us/creg/GreenCREG_Jan15.pdf.
24 For data on Texas revenue collections by major tax,
see “A Field Guide to the Taxes of Texas,” March 2015, Texas
Comptroller of Public Accounts, available at: http://www.
texastransparency.org/State_Finance/Revenue/pdf/Taxes_
Field_Guide.pdf.
25 See “State of Arizona: The Executive Budget – Summary, Fiscal Year 2016,” January 2015, available at: http://www.
ospb.state.az.us/documents/2015/Executive%20Budget%20
Summary%20Book,%20FINAL,%20Online%20Version,%20
with%20Links,%201-13-15.pdf.
26 Average state and local sales tax rates have been estimated by the Tax Foudation at: http://taxfoundation.org/article/
state-and-local-sales-tax-rates-2014.
27 The scenarios in this study assume that education services and medical services will remain exempt from sales taxes.
28 This estimates here are based on the same methodology outlined in: Stephen Slivinski, “A New Tax Plan for a
New Economy: How Eliminating the Income Tax Can Create
Jobs,” Goldwater Institute Policy Report No. 250, September
20, 2012, available at: https://goldwater-media.s3.amazonaws.
com/cms_page_media/2015/2/2/Policy%20Report%20
250%20New%20Tax%20System.pdf.
29 As a result of this new generous zero bracket, the family
tax credit could be eliminated as it would be redundant for the
purposes of shielding poor families from a marginal tax rate
that kicks in below the poverty line.
30 This would replace the current and somewhat arbitrary
system of depreciation rules for capital investment that creates
economic distortions.
31 Author’s estimates based on data from the Arizona Department of Revenue.
The Center for the Study of Economic Liberty (CSEL) is non-partisan academic unit within the W. P. Carey School of Business
at Arizona State University. Founded in 2014, CSEL is committed to the study of the role economic liberty and the free enterprise
system play in increasing opportunity and improving well-being. CSEL seeks to advance our understanding through scholarly
debate and research. Our scholars enjoy academic freedom and share a basic commitment to a freer, more prosperous world.
For more information, visit our website.
26
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